The Conversation We Should Be Having About Corporate Taxes

The corporate inversion — when a U.S. company takes on the legal identity of foreign subsidiary, usually in order to reduce its taxes — has become about as controversial as corporate finance topics get. President Obama has called such transactions “unpatriotic.” Others have defended them as a way for American companies to stay competitive in the face of a uniquely intrusive tax code.

Harvard Business School’s Mihir Desai and Bill George both fall mostly in the second camp, but with some surprising twists that came out when I spoke with them recently. Desai is a professor at Harvard Business School and Harvard Law School who has done a lot of research on corporate taxes, and wrote the July-August 2012 HBR article “A Better Way to Tax U.S. Businesses.” George is a professor at HBS and the former CEO of Medtronic, which has been involved in one of this year’s highest-profile inversion transactions, a merger with Ireland-based Covidien.

Part of our conversation was recorded for an HBR Ideacast, which you can listen to below. What follows that is an edited, much-condensed transcript of both the Ideacast and the progressively wonkier discussion that ensued after the podcast was done.

Mihir Desai: There was a wave in the early 2000s, and we shut them down with anti-inversion legislation. Now, instead of just being able to do it by yourself, the rules are such that you really have to have a foreign partner and there has to be a merger. As a consequence we now see these relatively high-profile mergers which facilitate the departure of U.S. companies. We have some of our largest and most innovative companies doing this.

So Bill, is the problem here — if there is a problem here — our corporate tax code or our corporate executives?

Bill George: The problem is definitely with the tax code. We have a dysfunctional tax code in the United States. We have among the highest tax rates anywhere in the world, and what’s happened is companies are paying taxes on foreign earnings that they generate overseas but they’re not bringing them back to the United States because they don’t want to pay at the U.S. corporate tax rate of 35%. You’ve got some $2 trillion of cash trapped overseas, so companies are looking for ways to use that cash effectively. It’s driven many U.S. companies to buy foreign companies, but in many cases they’d much rather deploy that cash in the United States.

One very interesting proposal came from Robert Reich, a liberal Democratic economist who recommended that the U.S. go to the system that almost all other industrial nations have of just taxing people where they earn the money. Personally I think that would solve the problem.

Mihir, you wrote an article for HBR a couple years ago on how to fix the U.S. corporate tax code, and I think this was one of the things you wanted to have happen. What were some of the other key changes?

Mihir Desai: This is the manifestation of two big problems. One is a high rate, and the second is this worldwide system, both of which are highly distinctive relative to the rest of the world. One of the things that’s happened recently is that leading countries like the UK and Japan, which used to look more like us, with relatively high rates and a worldwide system, have left. So now we’re really all alone — and that’s why these transactions are happening more.

A meaningful reform would combine two things. One, a considerably lower rate — and I think you need to get below 25% or 20% for it to be meaningful. And the second, as Bill mentioned, is a switch to a territorial regime. I actually am optimistic that we can get there; there’s a fair amount of consensus about that. The tricky part is where does the money come from to fund all of that, and there I think people divide up. My proposal has two particular sources of revenue-raising: One is that we have now large numbers of pass-through entities, and we have more business income in non-C-corporate form than we do in C-corporate form.

Like what kind of entities?

Mihir Desai: Those would be partnerships, those would be REITs, those would be subchapter S corporations — LLCs — and they have mushroomed wildly in the last 25-30 years. As a result the only people who pay the corporate tax are these large public multinationals, and that doesn’t make any sense. A small tax on those pass-through entities can help a lot. The second source of revenue is trying to change the fact that corporations report large profits to the capital markets and relatively small profits to tax authorities. If we make it more the case that you have to base your taxes on profit reports to capital markets, that can raise a fair amount of revenue as well.

Bill George: One issue I fear is how much money is going to be lost by the U.S. Treasury. When I’m talking to corporate CEOs, CFOs, and board members, I don’t see the major multinationals planning to bring that cash back to the United States. I was with the CFO of Apple the other day, and they’ve got $140 billion of cash trapped overseas. They aren’t planning to do an inversion, but on the other hand after tax they’re earning less than 1% on that money, compared to over 30% when they invest it in new products and R&D and innovation.

Mihir Desai: The amazing thing about Apple is they just decided to give back a lot of that cash in the form of dividends and share repurchases, but to fund it they’re not bringing the cash home from Ireland, they’re borrowing close to $40, $50 billion. Tim Cook in his testimony to the Senate committee said should I borrow money at 1% or should I pay 35% on my repatriated profit? The answer obviously is borrow at one.

One percent vs. 35%, that’s a really big difference. But at some level is there a conflict here, if you’re a CEO of a company — and you were one, Bill — between your obligation to your shareholders and others within your organization to minimize taxes, but then also your obligations as a citizen to not minimize them all the way to zero. What is the dividing line here? Is there one that we can identify?

Bill George: I’ve just spent many hours talking to Omar Ishrak, the CEO of Medtronic, who is involved in a major inversion, a $43 billion deal to purchase Covidien. The key question I asked him was, “Why are you doing this?” If he’s doing it for tax inversion, he’s got trouble. But he was very clear he was doing it to expand the Medtronic mission of helping patients — the strategy is a perfect fit, and it allows them to invest more money in innovation, ironically, because they can now use the $14 billion they have in cash trapped overseas to invest in the U.S.

Bill George: I was quite critical of Pfizer because I thought they were doing it for the wrong reasons. In fact Ian Read, the CEO, in his testimony to the British parliament, said he was doing it basically for two reasons, one for tax saving through the inversion and on the second to do all the savings he could by cutting people and combining. So I saw that in a very different context.

Back to the Medtronic example. Medtronic gets no tax savings. It already has an 18% tax rate and that’s about what they’re going to pay with Covidien. So there’s really no savings to them at the present time, but it does free up cash.

Mihir Desai: Bill’s example is interesting for two reasons. One is that we’re in such a crazy place that doing something that seems like it’s going to remove activity from the U.S. actually helps the U.S., because of all this capital that’s trapped overseas.

At the same time I do think your question puts your finger on something deep, which is there’s a growing distrust of corporations. When people see corporations doing this, they question their patriotism, as in fact the administration has. Corporations have to be more sensitive to this issue than I think they’ve been.

Bill George: There has been a lot of ill will over that and I think companies are going to have to step up and show their commitment to invest in the United States. Because this is the greatest place anywhere in the world to invest in innovation and R&D. As well as investing in social programs through their own philanthropy — I think many companies are stepping those up as well.

There is this argument from at least a minority of economists that the corporate tax is an abomination anyway, that we should just be taxing the shareholders — as we do, although right now we give them a lower tax rate — and not corporations. Do either of you think there’s any merit to that argument?

Mihir Desai: Well, yeah, I think there’s a fair amount of merit. And I don’t even know if it’s a minority. The corporate tax is a hard tax to like. It’s a hard tax to like because it’s a second layer of taxation and it’s entity-level taxation. So it’s always going to be dominated by a tax on individuals, because you’re giving another margin for distortion and another margin for evasion.

The reason why we might still like one, albeit it a low-rate one, is because without it you can run into some problems with individuals shielding and hiding their own income. Justin Fox Inc. can all of a sudden become a vehicle, if it’s got a zero rate, for shielding a lot of income. So we need a rate, and it’s probably positive.

One thing that’s really striking is how consistently, in polling, Americans of both parties, of all age groups, agree that the one group in this country that needs to pay more taxes than they do now is corporations.

Mihir Desai: It’s a puzzle. We know that corporations don’t per se pay taxes. That tax is going to be borne by shareholders, workers, or customers. Those are the only people who can actually end up paying the tax. So while people like to think about corporate tax reform as a sop to big business, the reality is that what we know about the corporate tax is it’s most likely borne by workers.

When you say it’s borne by the worker, you mean it comes out as lower wages?

Mihir Desai: Exactly right. It’s either the shareholders, the workers, or it’s going to be customers. And those other folks are pretty mobile. The workers aren’t.

Bill George: Just to illustrate that with an example. I serve on the board of Exxon, the world’s the second-largest market cap company. It’s very profitable. I don’t think that’s a bad thing. Exxon pays 45% tax on a global basis. Of course it affects dividend policy, it affects wage policy, it affects everything.

The real issue in our tax code is we’ve got a huge number of loopholes and a lot of favors given to various industries, and if we were to go to territorial tax system I think there’s a golden opportunity to get rid of a lot of these loopholes.

When you talk about loopholes, the reason why Apple and Google, they’re the most famous ones, have these massive piles of money overseas is because it’s income that they’ve paid almost no taxes on to any country at all. One of the questions is if you went to a territorial system and you didn’t fix these Double Irish Dutch tax sandwiches or whatever it is that they use to move income around, aren’t you just opening the door for a huge amount of abuse?

Mihir Desai: Let’s take Apple as one concrete example because the facts are relatively public. There’s $140 to $160 billion of offshore cash, $100 billion of it is in Ireland. Almost all of that $100 billion represents not profits earned in the U.S. but profits earned in Germany and Japan or China or wherever and then potentially shifted to Ireland. Do we care if Apple shifted money from Germany to Ireland? Frankly it’s not clear to me why the U.S. taxpayer cares about that. The German taxpayer should care about that, and the German taxpayer should be worried about it, and they should go after Apple if they want to. But why are we in the business of defending the German taxpayer?

Bill George: The one area the IRS and the Treasury would have to be very analytical and consistent on is transfer pricing. If companies are going to move technology ownership outside the United States, then you pay a substantial tax on that. That should be enforced. If you make products in the U.S., some of the profits should be captured in the U.S.

Let me give you specific example. Back in 1996, Medtronic made an arrangement to put a major defibrillator factory in Switzerland. The technology was all created in the United States, so what Medtronic did was sell that technology from Medtronic U.S. to Medtronic Switzerland, and pay a very substantial tax on that in the United States. After that it was governed by the Swiss tax system in terms of the profits made where manufactured.

With these companies where everything is intellectual property, and there aren’t factories moving from one country to another — Google is the really clear example of that — the tax authorities of the world seem to be struggling with how to do this correctly.

Mihir Desai: Absolutely, and one of the interesting things that’s on the horizon is the OECD has something called the Base Erosion and Profit Shifting initiative. They’re trying to come together and get at this idea of how does intellectual property get transferred and how do we value it. That’s a non-trivial problem.

The question politically is do we really think we’re going to get to a place where we have a multilateral organization, like the WTO, in taxes. I think the answer to that is, highly unlikely. That’s just a bridge too far for most people.

Bill George: You’re now getting into a much broader and more complex issue. With global corporations, they have to insure that they can be competitive around the world, and still be responsible to the national governments they serve. And there’s no such thing as global laws in many, many cases, including tax law. So you get a great deal of dysfunctionality, and I think this is why we need international bodies to help us work our way through these issues and sort them out.